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Start-Ups Slam Into Sarbanes

Kevin Kelleher

Bryce Linsenmayer knew Sarbanes-Oxley would affect his work as a corporate attorney. What surprised him was just how it did.

Last year, a client asked Linsenmayer, a partner at Haynes and Boone in Houston, about listing on the London Stock Exchange. Frontera Resources, a Texas-based company exploring for oil in the republic of Georgia, wanted closer access to European investors. But there was another reason driving its desire for a U.K. listing: Frontera was eager to avoid the millions in costs to comply with Sarbanes-Oxley.

As word of Frontera's British IPO spread, Linsenmayer began hearing from other small U.S. companies hoping to debut on the LSE's Alternative Investment Market for small companies. Again and again, Linsenmayer heard that one of the main reasons these start-ups were looking to list abroad was to sidestep Sarbanes-Oxley burdens.

"Sarbanes-Oxley is a huge factor for these companies," says Linsenmayer. "It's front and center in their minds. This is one of the things that could prevent Nasdaq from being a market for emerging companies."

Of the 30 U.S.-based companies that have listed on the AIM, 19 of them debuted last year. And more are in the pipeline: Linsenmayer says he's representing seven companies hoping for an IPO in London this year. Meanwhile, the LSE is canvassing the U.S. to get the word out. A seminar on the AIM that Hayes & Boon arranged with the London exchange last week drew more than 500 attendees.

It's been nearly four years since the Sarbanes-Oxley Act was born, aiming to improve financial disclosure and corporate governance. The House version of the bill was passed in April 2002, followed by a stricter version in the Senate. Following a series of financial frauds at companies such as Enron, Tyco and WorldCom, the stricter version won out.

After nearly four years, the debate is raging over whether the new law is helping or hurting. The Securities and Exchange Commission is considering recommendations from an advisory panel that would spare companies with less than $750 million in market cap from some of the costlier and more onerous provisions.

It's not surprising that the first fixes to the law would be for small companies. Of all the complaints about Sarbanes-Oxley, the loudest and most frequent are coming from small companies and their backers. Venture capitalists in particular are concerned that the cost and complexity of Sarbanes-Oxley compliance are preventing many emerging companies from listing on U.S. exchanges.

Corporate griping about the new law is being kept to the boardroom, however. "It's very difficult for an executive, say a CEO or a CFO, to publicly bemoan Sarbanes-Oxley," says Alex Slusky, a managing partner of Vector Capital. "They're afraid it would sound like they're not honest about rules meant to protect investors."

There are parts of Sarbanes-Oxley that few object to, such as requiring CEOs and CFOs certify financial reports or auditor independence. But others are causing problems, VCs say, including the demand that only independent directors be placed on a company's audit committee. Often, that means recruiting a director to the board who has little or no knowledge of the company and its industry.

By far, the biggest sticking point for small companies and their investors is Section 404, which requires companies to produce an annual control report including an assessment of how well those controls are working. That entailed introducing IT systems to manage financial data and countless hours spent with auditors. All of this not only forced start-ups to pay new fees, it often also sucked up a good deal of management time.

Initially, the SEC estimated that Sarbanes-Oxley compliance would cost companies around $91,000 over the first three years. But some say small companies are seeing their costs as high as $4 million.

A study last December from CRA International found that companies with market caps between $75 million and $700 million paid an average of $2.4 million in compliance costs in the first two years. (The silver lining: Costs dropped 39% in the second year to $900,000 from $1.5 million.)

"I haven't heard anyone make an argument that the benefit from Sarbanes-Oxley is worth $2 million to $3 million a year," says Bob Pavey, a general partner at the venture firm Morgenthaler. "I don't believe the companies we've taken public needed more transparency. It's just added significantly more costs and a level of bureaucracy."

Many companies that would otherwise entertain dreams of going public on a U.S. stock exchange are instead opting for other exit strategies. Most commonly, they are being bought out by other companies, although that has its disadvantages.

"Companies going public do so because they believe they and their shareholders will be better served by staying independent and being able to grow on their own," Pavey says.

The reluctant attitude toward IPOs is reflected in the trickle of venture-backed companies making it into the public markets. According to the National Venture Capital Association, 56 venture-backed companies went public in 2005, down from 93 IPOs in the previous year and 264 in the go-go year of 2000. But 330 were bought or acquired in 2005, even with 339 in 2004 and above 317 in 2000.

For the smallest companies, however, the new laws haven't dampened interest in raising money in the capital markets. Last year was a record year for companies filing SB-2 offerings -- there was a total of 882, compared with 800 in 2004 and 738 in 2000. SB-2 companies aren't required to have their internal controls audited, though many are choosing to do so voluntarily.

Of course, there are other factors keeping the IPO market relatively quiet, notably the continuing fallout from the dot-com crash. "My guess is that venture-backed IPOs would still be somewhat subdued without Sarbanes-Oxley," says Charles Harris, who heads up the New York-based nanotechnology venture firm Harris & Harris. "Other factors that helped IPOs take place have changed, such as the practice of analysts attending roadshows."

But anecdotal evidence suggests that the perception of the onerous costs involved with new compliance laws is taking its toll. "People just don't want to talk about an IPO anymore," says Vector Capital's Slusky. "They want to sell."

Vector has been another of the unintentional beneficiaries of Sarbanes-Oxley. The buyout firm has found some companies willing to go private rather than bear the costs of compliance and auditing.

"We took Register.com private partly because of the extraordinary burden of Sarbanes-Oxley. It was going to spend nearly one-third of its net revenue on Sarbanes-Oxley and other public-company costs," Slusky says. "This law has been very good for our business."

This is the first part of a three-part feature on Sarbanes-Oxley and its effects. Other stories will focus on the impact on investors and efforts to modify the law.